Commodities crater on inflation outlook, economy

Fed's warning on inflation, renewed economic fears take steam out of rally

By

LauraMandaro

SAN FRANCISCO (MarketWatch) -- Prices in oil, gold, wheat and other commodities took a dive Wednesday, one day after the Federal Reserve highlighted its inflation concerns as it cut rates and indirectly took away some of the fizz from the recent commodity rally.

The Fed's rate cut of 75 basis points, less than the market expected, and its statement acknowledging the threat of inflation served as "fair warning to commodity speculators," according to William Knapp, managing director at New York Life Investment Management's Equity Investor's Group.

In past weeks, inflation worries, fueled in part by the Fed's focus in recent months on cutting rates to spur growth, sent investors flocking to oil, gold and grains as safe-haven investments. The weak dollar, which had fallen alongside the rate cuts, had also helped push these dollar-denominated commodities to record highs.

Some of that inflation-momentum disappeared Wednesday. In its place, renewed fretting over global economic growth and the U.S. financial system, a strengthening dollar and rush to raise cash by overleveraged investors punished commodities.

"Many fast money investors, hedge funds, are long commodities and you sell what you can when you got garbage like mortgage-backed securities and you need to get liquidity," said Barry Ritholz, CEO and director of equity research at Fusion IQ.

Oil futures lost 4.5% to end at $104.48 a barrel on the New York Mercantile Exchange, its biggest daily loss since 1991. See more on oil.

Gold for April delivery, which hit a record high of $1,034 an ounce Monday, plunged $59, or 5.9%, to finish at $945.30 an ounce, its biggest one-day drop since June 2006. Read Metal Futures.

Wheat futures lost 7.7% to end at $10.74 a bushel.

"A strategy designed to use base commodities to protect investors from inflation, at a time when economic growth is slowing and underlying demand for commodities is weakening, is unsustainable," said Thorsten Fischer, an economist at the Royal Bank of Scotland.

Fed tackles inflation

To boost a U.S. economy besieged by the housing slump and the credit crisis, the central bank has brought down interest rates to 2.25%, its lowest level since December 2004.

The Fed's aggressive rate cuts since last year have taken their toll on the dollar, while the expected surge in liquidity down the line has fueled inflation expectations and helped fuel the boom in commodities.

The Fed's move on Tuesday threw some cold water on those views. In its statement, the Fed signaled that it wasn't as convinced as it had been earlier that prices increases would moderate. "Still, uncertainty about the inflation outlook has increased," the statement warned.

"The additional attention to inflation, especially the suggestion that inflation expectations had picked up, suggested that less aggressive action is possible, even likely, in coming months," Daiwa Securities economist Mike Moran wrote in emailed comments.

The dollar rallied on Tuesday and maintained a firm tone Wednesday. A stronger dollar pressures demand for dollar-denominated commodities, such as crude and gold, which become more expensive for holders of other currencies.

Before Tuesday, expectations of a 100 basis-point cut "played into the whole commodity side, with anticipation of a huge cut feeding into that ephemeral yet still-to-be-proven demand for all these commodities," said Knapp.

Financial, growth concerns persist

At the same time, concerns about the financial crisis are also leading some investors to question its impact on already ailing U.S. economy, and by extent on global growth.

"Participants are feeling very nervous about the implications of difficulties in the financial sector" and what this means for the "broader economy," said Gayle Berry, associate director in commodities research at Barclays Capital in London.

She warned big swings in prices, like the ones seen Wednesday, will be repeated in coming months "until a more certain direction is demonstrated by the U.S. economy."

The Dow Jones-AIG Commodity Index, which reflects a basket of energy, metals and agricultural commodities futures, tumbled 4% to a level not seen since mid-February. Silver, whose price fell more than 7% on Wednesday, and wheat were some of the biggest movers.

The swift descent across the commodities spectrum took some steam out of a several-week run in prices.

"Prices had reached such high levels that a pullback at some point was inevitable," said Daniel Raab, a managing director in commodities at American International Group Inc.
AIG, +0.21%

AIG publishes the commodity benchmark with Dow Jones & Co., the publisher of MarketWatch, who is owned by News Corp.

The surprise comes in the timing of the sell-off. Commodities largely had shouldered a series of news events that whipsawed stock and bond markets this week, starting with the public-private bailout of Bear Stearns Cos.
BSC, +0.00%
and a string of weak U.S. economic reports.

Prior to cutting its key rate on Wednesday, the Fed took extraordinary steps over the weekend, cutting its discount rate and approving a deal for J.P. Morgan Chase & Co.
JPM, -0.19%
to buy Bear Stearns Cos. for $2 a share.

"Some of this sell-off in commodities [with gold at the forefront] can also be attributed to the perceptions that fears are lifting somewhat in the financial markets," said Jon Nadler, a Montreal-based senior analyst at Kitco.

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